My financial adviser is retirement expert Phil DeMuth PhD author of about 12 books on finance and a contributor to Forbes. Every quarter he dutifully pens a letter keeping the troops under his tutelage informed of developments. I wrote a piece on the secure act last month, but this letter’s content is far more extensive. Be afraid, be very afraid
The SECURE Act: Implications for your Retirement
Accounts and Estate Planning: Sometimes a piece of legislation is so terrible that both parties immediately fall in love with it, and this is the case with the Secure Act. It passed the House with an overwhelming majority and is widely expected to pass the Senate soon. The Secure Act covers all the main retirement vehicles: Traditional IRAs, Roth IRAs, SEP IRAs, Simple IRAs, 401(k)s, 403(b), and 457 plans. The legislation is so important that I want to discuss it in detail. I hope it does not pass, but if it does, you will want to be thinking about how it affects you and how to respond.
Background: The main sponsor of the Secure Act is the insurance industry. They are lobbying hard and have our representatives on speed dial. Why? The Secure Act mandates that an annuity payout be offered as an option in all retirement plans. Insurance companies sold $230,000,000,000 worth of annuities in 2018, and their goal is to sell even more.
Annuitizing your retirement plan assets is a bad idea unless:
You need all the cash for living expenses (you have no bequest motives)
You can find an annuity that indexed to CPI-E, the inflation rate facing senior citizens that includes their increasingly expensive medical care
It is indexed to our rising standard of living
It has the lowest possible default risk
It is low-cost
Unfortunately, such an annuity doesn’t exist. Congress eyes your retirement accounts as a giant piggy bank. The mandatory offer of an annuity is a slippery slope that could lead to the mandatory annuitization of all retirement accounts in the future. This would shoehorn the distributions into higher tax brackets, raise revenues, and eliminate the “problem” of the inherited IRA. Best of all, politicians would get to accomplish this without “raising taxes.” But that is a problem for another day.
The issue before us is that the Secure Act would be an estate planning catastrophe for people with large IRAs. It takes the sensible planning done up until now and stands it on its head. What is the problem? The Secure Act eliminates the stretch IRA. The stretch IRA let you leave your retirement accounts to your children or grandchildren or other heirs, who then parcel out the required minimum distributions (RMDs)over their actuarial lifetimes. The payout might be small for a child but would grow over the decades until the inherited IRA would comfortably provide for the child’s retirement. A parent could die with the knowledge that, whatever vicissitudes their children might experience in life, they would have freedom from want in old age. What a wonderful legacy. Congress wants to kill it. In exchange, they plan to let you postpone taking your first required minimum distribution for a year and a half – until age 72.
How it would work: The Secure Act forces non-spouse beneficiaries to pull out all the money from your IRA over ten years. (The original Senate plan was even worse: 5 years). A surviving spouse can pull the money out over his or her actuarial lifetime (or yours, if preferable). A child can pull it out over his or her actuarial lifetime up to age 21 but then must takeout the remainder over ten years. Only beneficiaries who are disabled or fewer than ten years younger than the account owner are exempt from this ten-year pullout rule. If you skip a generation and leave the IRA to your 5-year-old granddaughter, she must take the money out over ten years. Under the Kiddie Tax, it would be taxed at her parent’s rates. Only your children (not your grandchildren) can use the actuarial payouts up to age 21. Before, the best approach was to leave your IRA to your kids or grand-kids and stretch the payout over decades. Now the longest stretch might be with your surviving spouse – who likely will be paying taxes in the higher “filing single” tax bracket.
The bracket jump a surviving spouse experiences can easily go from 12% to 25% or from 24% to 35%, especially as the mandatory payout ratios automatically increase with age. For example, the RMD for a seventy-year-old is 3.7% of the retirement account balance, but for a ninety-year-old, this rises to 8.8%. In most cases, the IRA will eventually pass to adult children. If a million-dollar IRA ends up in the hands of an attorney/daughter, she will have to add $100,000 of annual income on top of her six-figure salary for a decade. As much as half might be swallowed by taxes. The effect is to make more of your IRA subject to higher taxes sooner, as distributions are forced out in bigger chunks that are subject to higher tax rates under our progressive tax code. This is not what the government promised us when we were making all those contributions, but there it is.
By the way, the Secure Act is also a college planning catastrophe for middle-class parents. The temporary but jumbo, highly taxed mandatory distributions from inherited IRAs will make these families spuriously appear high-income on the Free Application for Federal Student Aid, ruining their prospects for need-based financial aid. The ten-year mandatory IRA payout will look like a Christmas goose to colleges. The result is the opposite of what the grandparents intended. The Secure Act lowers the value of retirement plans – perhaps not for the half of the population who pay no Federal income tax – but very possibly for you. Our estate planning options for them have become much more unwieldy.
Using a Trust In the past, many estate attorneys would cut and paste the boilerplate from Natalie Choate’s IRA book to establish trusts that could stretch the IRA distributions, rather than having the IRAs pass directly to human beneficiaries. One appropriate use for a trust might be if you had beneficiaries who were young and you didn’t want, say, your 8-year-old grandson to get unfettered access to a million dollar IRA when he turned 18. What happens under the Secure Act? Since there are no longer any “Required Minimum Distributions,” the trust receives nothing for the first nine years. Then year ten, by law, the IRA must pay out everything. Now the kid turns 18, and suddenly he gets $1,000,000. With a decade of additional compound growth, it might be $2,000,000. All delivered in one year, so most of it is taxed at the highest Federal and state brackets. The money that remains is his to spend. Once again, we have the exact situation the grandparents set up the trust to prevent.
Recommendations: Broadly, there are two kinds of trusts that people use here. One is a conduit trust, where the trust passes through all the income to its beneficiaries every year. The other is a discretionary trust, where the trustee decides what gets paid out to each beneficiary every year. In the example above, we saw the conduit trust makes Johnny a millionaire at age 18. If this were a discretionary trust, the trustee could withhold the distribution. But trust tax rates start at 37% on only $12,500 worth of income, and state taxes are on top of that. We can postpone giving the money to Johnny, but the taxes would be severe. If you want to use a conduit trust, take the money out in equal installments over ten years and try to distribute it over as many beneficiaries as possible (kids, grand-kids) so that no one’s taxes are raised unduly. Most kids up to age 24 will be taxed at their parent’s rates due to the Kiddie Tax. If you are going to use a discretionary trust, convert your traditional IRA to a Roth first. That way the distribution to the trust might be postponed for another ten years while it grows untaxed, and then the tax-free distribution can stay in the trust until the trustee parcels it out. The only further taxes would be on the earnings within the trust until it was distributed to its beneficiaries. These can be mitigated by the use of zero dividend stocks like Berkshire Hathaway. But – if you are considering this Roth IRA approach, then the question arises whether you would be better off taking the money earmarked to pay the taxes on the Roth conversion and using it to buy a universal life insurance policy inside an Irrevocable Life Insurance Trust (ILIT) for the beneficiaries instead. That money is out of your estate no matter what happens to the current $11.4 million estate tax exemption and the proceeds from this ILIT would go tax-free to your heirs, distributed on terms that you set. You can model it both ways – Roth vs. ILIT – to see which seems most economically advantageous.
Using a Charitable Remainder Unit Trust Families with large IRAs and some measure of charitable intent could make a Charitable Remainder Unit Trust (CRUT) the beneficiary of a traditional IRA. This maneuver reconstructs the stretch provisions of the inherited IRA that the Secure Act abolishes. The CRUT needs to file a tax return every year but offers you the flexibility to set it up and invest it yourself. There is no reason why the final charity couldn’t be your family’s donor-advised fund if you so choose (although not your private family foundation). The CRUT sells the IRA assets but does not pay taxes. Your estate receives the amount that will eventually go to charity – 10% at a minimum – as a tax deduction. Meanwhile, the beneficiaries receive, say, 10% of the account balance per year for twenty years. They pay taxes on that as ordinary income. If the CRUT is invested successfully, beneficiaries could even burn through the initial contribution and eventually receive distributions taxed as capital gains. As one attorney told me who is doing this with his own estate, there are plenty of ways to screw it up. There are rules to be carefully followed. Talk it through in advance with your custodian and trustee to make sure everything is in good order – especially the beneficiary forms – so the IRA flows seamlessly to the new CRUT. It will probably work best where the IRA and the CRUT have the same custodian. If you don’t want all this trouble, big charities are happy to let you use the CRUTs they manage if you are willing to leave the remainder to them.
Action Item: A rule of thumb is that you use a trust when you don’t trust. If your beneficiaries can be people (responsible adults who unlikely to be sued) that is always easiest and cheapest since you avoid the expenses of drafting trusts, using trustees, and filing trust tax returns every year while paying trust tax rates. We can change beneficiaries easily by submitting a piece of paper to Fidelity. If your retirement accounts currently name a trust as the beneficiary, you should contact your attorney if/when the Secure Act passes to determine whether the trust as written still achieves your objectives. One red flag would be any mention of “required minimum distributions” or other actuarial-based withdrawals from the IRA in the trust documents. Your trust would have to work with the new ten-year withdrawal rule.
Superb analysis IMHO!